Annaly Capital Management, Inc. (NLY), American Capital Agency Corp. (AGNC): Further Rebalancing to Help These mREITs

Amid concerns regarding QE unwinding, agency mREITs have experienced their biggest slide since October 2011 reports Bloomberg. A lot has been said about the sustainability of the sector’s business model, and some have even marked the mREITs as a toxic investment. However, I am bullish on the sector and recommend long-term investors consider accumulating Agency mREITs on continued weakness. In particular, I favor the most well managed American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY) and Capstead Mortgage Corporation (NYSE:CMO).

The business model

Agency mREITs hold portfolios of residential mortgage backed securities that are issued and guaranteed by any of the government agencies including Freddie Mac and Fannie Mae. These asset portfolios are leveraged so that the returns can be magnified in order to provide elevated returns to shareholders.

The returns on residential Agency MBS are highly dependent on the prevailing interest rates, and so is the cost of funds. The difference between the asset return and cost of funds is known as the net interest rate spread.

Since the returns are leveraged, slight moves in the interest rates have a devastating impact on the book value, the net interest rate spread and finally the dividend rate. The accelerated prepayments over the last few quarters combined with the current rising rates environment have caused many investors to question the business model. However, I believe the business model concerns are invalid, and investors with a long-term perspective must take advantage of the current weakness and start accumulating the mREITs into their high dividend yielding portfolios.

Largest weakness since 2011

The interest rates have started climbing higher since the beginning of the year, owing to concerns regarding an early exit by the Fed from the Agency MBS markets. These higher rates have multiple effects on the mortgage REITs sector as noted above, but the most profound is the decline in the book values. It’s critically important for the mREITs because the mREITs trade in proximity to their book values. A decline in the book value means a decline in the stock price.

Mortgage REIT ETFs iShares FTSE NAREIT Mortgage REITs Index ETF (REM) and the Market Vectors Mortgage REIT Income ETF (MORT) fell 12% each since the start of the year, while Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) fell 18% and 29%, respectively. Capstead Mortgage Corporation (NYSE:CMO) was spared and only fell 0.5% since the beginning of the year.

The continued weakness in the sector is not the only bullish factor. The efforts made by some of the mREITs also make me bullish on these stocks.

The largest mREIT

Annaly Capital Management, Inc. (NYSE:NLY)The largest REIT, Annaly Capital Management, Inc. (NYSE:NLY), was proactive about the changes in the interest rates, which is why it made some efforts to secure its book value and the net income. Looking at the compression and volatility in spreads, Annaly acquired CreXus Investments. The effect has been higher earnings coming from the commercial MBS markets. The presence of CRE loans and relatively lower level of leverage will help the company to report lower book value erosion in the coming quarters.

Credit: Annaly Capital Management, Inc. (NYSE:NLY)

Some other steps that the management can take include getting rid of some of its exposure in the 30-year fixed rate Agency paper. This is considered most sensitive to moves in interest rates. Since Annaly Capital Management, Inc. (NYSE:NLY) is exclusively invested in fixed rate Agency MBS, the 30-year fixed security accounts for a large part of the entire portfolio.

More rebalancing could help

American Capital Agency Corp. (NASDAQ:AGNC) conducted a rebalancing exercise recently, which includes reducing exposure to the 30-year fixed rate Agency MBS and reassuring its resolve to actively manage its assets and hedges. While these efforts would bear positive results in terms of reducing book value volatility, I believe these will result in lower earnings potential.

So, further rebalancing could help American Capital Agency Corp. (NASDAQ:AGNC). The company is also currently exclusively invested in the fixed rate Agency MBS.